We describe a rational expectations model in which speculative bubbles in house
prices can emerge. When a bubble emerges, both speculators and their lenders prefer interest-only (IO) mortgages to traditional mortgages. By contrast, absent a bubble there is no scope for mutual gains from using IOs. Using data compiled for over 200 US cities for the period 2000-2008, we find that IOs were used sparingly in cities where elastic housing supply kept house prices in check, but were common in cities with inelastic supply where house prices rose sharply and then crashed. We confirm that the use of IOs in these cities is not proxying for other mortgage market characteristics such as subprime, securitization, or high leverage. Moreover, the use of IOs does not appear to have been a response to houses becoming more expensive; if anything, their use anticipated future appreciation. We also confirm that, as implied by our model, IOs were more likely to be repaid early, and those that survived until prices fell were more likely to default. These findings suggest that the recent boom-bust in the housing market was associated with a speculative bubble.